Whenever coins containing precious metals have been used along with base metal coins of the same denomination, both legally accepted as tender, the bad coins have driven the good coins out of circulation.
Gresham's Law is named after Sir Thomas Gresham, an English financier in the time of the Tudors who died in 1579. However, the original principle had been stated at least forty years before by Nicolaus Copernicus, and has been credited to Christian and Islamic scholars even before that. In some parts of the world (mostly Central and Eastern Europe) the law is still known as the Copernicus Law.
The idea may practically date back as far as the Athenian playwright Aristophenes. In his play The Frogs, Aristophenes compares the degradation of great politicians to the introduction of bad coinage.
I'll tell you what I think about the way
This city treats her soundest men today:
By coincidence more sad than funny,
It's very like the way we treat our money.
The noble silver drachma, which of old
We were so proud of, and the one of gold
Coins that rang so true
Throughout the world have ceased to circulate.
Instead the purses of Athenian shoppers
Are full of phoney silver-plated coppers.
Just so, when men are needed by the nation,
The best have withdrawn from circulation.
The coinage problem is mostly obsolete in the modern age, but the practical problems are as large as ever.
The outcome described by Aristophenes is common in competing human groups or organizations: When bad behavior has taken root, and that bad behavior has a “survival advantage” against good behavior, it becomes difficult, and occasionally impossible, to drive out the bad behavior; a process akin to natural selection.
In fact, one might call Gresham's Law something of a special case of natural selection itself. Forms of human behavior survive because they have a competitive edge against other behaviors. Self-interested groups naturally tend towards what works, so bad drives out good (in a moral sense) if it causes superior practical effects. This is one large reason why forms of regulation and policing are needed in human systems, to prevent the Law from working its magic.
In a wonderful illustration of this tendency, Charlie Munger applied Gresham's Law to 1980s savings and loan banking practices in his 1984 Letter to Wesco Shareholders:
Although interest rates have subsided from the 1981-82 peak, the low and slowly changing interest rates of former years are plainly gone with the wind, as are the former government-decreed limits on interest rate competition for savings accounts and the favouritism for savings and loan associations over banks. But an agency of the U.S. Government (…) continues to insure savings accounts in the savings and loan industry, just as it did before. The result may well be bolder and bolder conduct by many savings and loan associations. A sort of Gresham's Law (“bad loan practice drives out good”) may take effect for fully competitive but deposit-insured institutions, through increased copying by cautious institutions of whatever apparent-high-yield loan and investment strategies seem to allow competitors to bid away their savings accounts and yet report substantial earnings. If so, if “bold conduct drives out conservative conduct,” there eventually could be widespread insolvencies caused by bold credit extensions come to grief.
This can be common in some business fields. Take two drug salespeople – one willing to bribe doctors in order to make sales, and one not willing to do so. If the industry functions such that fraudulent business practices are not punished, and the bribery goes uncovered by the buyer's organization, then bribery obviously gains a sustainable competitive advantage over non-bribery. Clearly, the deceptive practice will take hold, as salespeople unburdened by morals are promoted and compensated better than the high-roaders. It's a clear form of Gresham's Law.
Take also sub-prime mortgage lending practices in the lead up to the 2008 financial crisis. If two banks are competing for borrowers and one lets their standards slide to zero (or less), which is likely to prevail? Even if the practice is a “long-term loser,” it can still take hold in systems where short-term incentives provide encouragement to the actual decision makers.
Canadian Prime Minister Mackenzie King once described the origins of Gresham's Law and its effects in a similar fashion, dubbing it the Law of Competing Standards.
In the reign of Queen Elizabeth, an official named Gresham observed that where different metals were in circulation as coinage and some were better than others of the same nominal value, the coins made of the inferior metal tended to drive the better out of circulation. The better coins were either hoarded or melted down and sold as bullion, were used in the fine arts, or were absorbed in the foreign exchanges. In other words, what Gresham discovered was that cheaper money tends to drive out dearer; that when people begin to discriminate between two coinages, they will invariably pay out the inferior and hoard the better, thus removing the better from circulation. This phenomenon once generally observed came to be described as a “Law,” and was identified with Gresham' s name, since it was Gresham who was first successful in drawing public attention to it. Amongst money-changers, Gresham' s Law of the precious metals is better known than the Ten Commandments.
Something analogous to Gresham's Law will be found to obtain in the case of competing standards in Industry. Assuming there is indifference in the matter of choice between competing commodities or services, but that in the case of such commodities or services the labor standards involved vary, the inferior standard, if brought in this manner into competition with a higher standard, will drive it out, or drag the higher down to its level. This is effected by the opportunity of under-selling which comes, where in such cases human well-being is sacrificed to material ends. The superior standard, not being recognized or demanded, is unable to hold its own, and in time disappears. This Law is just as real and relentless in its operation in Industry as Gresham's Law of the precious metals is with respect to money and the mechanism of exchange. Indeed, a more accurate exposition would describe both as manifestations of one and the same law, which I propose to call the Law of Competing Standards. I see no reason why economists should not recognize the existence of such a law, and incorporate it immediately in economic science as being quite as significant as the Law of Supply and Demand, the Law of Diminishing Returns, or any other Law accorded a place in its nomenclature.
The Law of Competing Standards is doubtless a part of the general Law of Competition, under which the cheaper of two commodities gains in competition a preference over the dearer. What Gresham discovered was an important sequence of the Law of Competition as applied to coinage; namely, the disappearance, in the course of time, of the superior metals. Observance of a like sequence in the case of standards in Industry is highly desirable. As respects labor standards, I believe that recognition of the operation of the Law of Competing Standards over ever-widening areas would do more than aught else to clear up the most baffling problems with which Industry is confronted, and to point the way to a solution of many situations which hitherto have seemed incapable of solution.
One practical application of Gresham's Law, and perhaps the most important, is to avoid becoming part of systems where good behavior cannot win due to the nature of the Law. There are certain industries and human activities that lack the “policing” necessary to keep systems of behavior on the straight and narrow, and thus bad behavior has gained a hard-to-replace foothold. While it's admirable to be the “cleanest shirt” in a pile of dirty laundry, certain areas of human life do not allow the clean shirts to win.
On the flip side, you'll occasionally find situations where the good money drives out bad, and the cleanest shirts end up being worn the most. Those are the areas to aim your focus.
Gresham's Law is one of Farnam Street's Latticework of Mental Models.